One Sherpa

Having worked around finance all my life the thing that makes me wonder is why everything seems so complicated when explained by an expert.

Below is a great comment from David Butcher who commented on my first video on George which many of you may have seen.

David’s comments raise some great points which reflect views held by quite a large portion of the community so I would like to have further discussion on his points. I will explain further our perspective on some of them in this post.

“Andee
This is quite misleading. The problem with generalisations is that everyone’s circumstances are different.

If George had a rigorous investment analysis he MAY have had a smile on his face! You have forgotten tax benefits which can be substantial. Also, the actual equity needed to purchase his investment could have been minimal compared to the purchase price. Most importantly, over time the tenant and the tax man pay for the majority of his invesment.

Cashflow is an important element when assessing an individual’s capacity to buy into an investment property, and provided his projected debt to equity ratio (based on worst case scenario assessment) is comfortable, he MAY be able to use the increase in equity for his investment property to liquidate the debt on his principal residence.

He would then have GOOD debt (tax-effective) and would liquidated his BAD debt. Of course property prices, like equities, can fall, and interest rates can rise. But his interest rate (after tax and deductions) could be around half that he is paying on his own residence and, most importantly, he takes a long-term view on property investment which historically has doubled in value every 8-10 years.

I know you are looking at the impact of cash income, but generalisations such as yours cannot be applied to everyone
Cheers”

Understand The Basics First
The reason we use a very simple example is to help people who have limited grounding in the nuances of investment understand the basic principles so they don’t get lost in the possible scenarios that experienced and professional investors might embark on.

If the simple principles are not clearly understood, then errors can be made on more complex transactions and strategies.

True wealth and real financial feedom comes from having sustainable income streams that exceed all our expenses not from having lots of accumulated value “on paper”

Tax Benefits Need Income
In order to get a tax deduction, you must first have some income to deduct against. This is why many sellers of investments look to people with high incomes who have high PAYG tax against which they can deduct LOSSES from investments in order to get a future capital gain.

The point here is that while it may be prudent to get a tax deduction, they only materialise if you have made an overall profit somewhere else that you can deduct against. Other wise you would have created net income and that would increase your tax.

Understand the True Cost of Your property Investment?
David also makes the point that with an investment property, you can get the tax man and the tenant to help you pay off the investment and therefore get a free ride into more wealth. While this is correct, it only relates to PART of the investment cost, and is often more than offset by the huge amounts of interest being paid out on the loans.

Will 400% Debt to Equity Make You Financially Free?
Another consideration is that the way most investment properties are funded means investors have to keep tipping in some of their own cash to keep the opportunity for future capital gain alive. The most common funding mechanism used is 80% LVR which means that you have $4 debt for every $1 of equity. Banks are really happy to do this because they know that the loans will be very difficult to pay off and they will have a long term interest return from the ‘buy and hold’ property investor.

To keep the maths simple let’s assume the property costs $100 and the loan is $80. The rental return before any repairs etc etc at 3% yield would be $3. The interest cost on $80 at 6% would be $4.80 which is a loss of $1.80 for which the investor can get a tax deduction. Now this is what they do for getting a capital gain in the future and long term wealth. So in these situations the bank get their return in CASH and the long term investor gets their return in NON CASH capital gain.

Understand What Returns You Are Actually Getting?
The last point is to address the notion of properties doubling in value over a ten year period. This of course sounds really good and in my view is way better than doing nothing. BUT think about it for a moment. Doubling in ten years is about 10% increase per year. That’s about 7 % compound growth and what do you get in the end. NO CASH unless you sell your precious piece of capital.

That’s why our approach is to look at ongoing cash flow throughout the term of investment. Many people are known as asset rich and cash poor which is becoming increasingly stressful as their current cash flow comes under pressure.

It’s Cash flow That Buys The Groceries
The main reason for this is that they have been focusing too much on SPECULATIVE CAPITAL GAIN and not strongly enough on the CASH RETURN. from that capital I believe strongly that people must take a business mindset to their investment which means looking to add value at every step of the way and also build sustainable cash flow throughout the life of the investment.

What Do You Think?
This whole topic is of significant importance given the recent change in economic conditions. People are reviewing their strategies and as a result I would welcome further comment from you so that we can all learn from each other.